The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Wednesday, July 10, 2013

Ha-Joon Chang: Welcome to the age of irresponsibility

In an excellent column in the Guardian, Ha-Joon Chang talks about our modern era of irresponsibility where there is so much complexity that no one is expected to really know what is going on.

Mr. Chang uses finance as one of his examples where complexity threatens an endless series of crises.

Complexity is one of the methods that Wall Street uses to introduce opacity into the financial system. Opacity that allows Wall Street to profit from the resulting mis-pricing of risk. Opacity that allows Wall Street to dodge responsibility for the consequences of this mis-pricing of risk and mis-allocation of capital.

The problem is even more serious in the financial sector, which these days deals in assets that involve households (in the case of mortgages), companies and governments all over the world. On top of that these financial assets are combined, sliced and diced many times over, to produce highly complicated "derivative" products.

The result is an exponential increase in complexity.

Andy Haldane, executive director of financial stability at the Bank of England, once pointed out that in order to fully understand a CDO2 – one of the more complicated financial derivatives (but not the most complicated) – a prospective investor needs to absorb more than a billion pages of information.

I have come across bankers who confessed that they had derivative contracts running to a few hundred pages, which they naturally didn't have time to read.

Given this level of complexity, financial companies have come to rely heavily on countless others – stock analysts, financial journalists, credit-rating agencies, you name it – for information and, more importantly, making judgments.

The result is an economic system in which no one in "responsible" positions takes any serious responsibility. Unless radical action is taken, we will see many more financial crises and corporate scandals in the years to come.

Please re-read the highlighted text as Mr. Chang makes a very important point about how complexity has reduced, if not eliminated, the sense of responsibility for exposures taken on and the losses incurred if something goes wrong.

Under the FDR Framework, market participants are responsible under the principle of caveat emptor (buyer beware) for all losses on their exposures. This gives them an incentive to independently assess the risk of an investment using all the useful, relevant information disclosed and limiting their investment to what they can afford to lose.

But what if the experts fail to accurately represent their abilities to the market participants?

We end up with the situation that Mr. Chang describes where no-one has responsibility.

Regular readers know that the opaque structured finance market is exactly the type of situation where Wall Street reaps massive profits from opacity while dodging any responsibility for the consequences while the experts failed to represent that they were blindly betting the market participants' money.

But what happens if there is opacity and there is no information to independently assess?

Then we have the situation with the 'black box' banks where at the start of the financial crisis even the banks could not tell which banks are solvent and which are not. In this case, taxpayers bailout market participants for the regulators failure to ensure transparency.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.